CIO sees 60/40 as “bent, but not broken”

The combination of supply-side shocks to inflation and energy price headwinds to growth stemming from the US-Israeli war with Iran may have some investors flashing back to 2022’s bear market. In the weeks since the war began and the Strait of Hormuz was closed, market performance has rhymed with 2022. Stocks and bonds have experienced positive correlation, bucking the wisdom of the 60/40 ‘balanced’ portfolio. Bonds have fallen on the revision of hoped-for central bank rate cuts, especially in the US. Stocks have fallen due to broad risk-off sentiment as well as the prospect of high energy prices derailing growth. Despite weeks of weakness across the 60/40, one CIO still believes that a balanced approach can work, perhaps with a few tweaks.

David Stonehouse, Interim Chief Investment Officer and Head of North American and Specialty Investments at AGF Investments, explains that there have been some glimmers of hope for balanced portfolios as bond markets have begun to recover and show negative correlations to equities again. He notes that while a brief moment of positive correlation is notable, this moment doesn’t fully resemble the extremes of 2022. He argues, though, that a gradual shift in strategy may be warranted to protect against future periods of positive correlation.

“[The 60/40] is bent, and has maybe suffered a couple of fractures, but it’s not broken,” Stonehouse says. “The obvious thing that happened over the past four weeks was that bonds got hurt. The slightly less obvious thing was that stocks got hurt. But the two of them have been positively correlated for the last four weeks. What was interesting about Friday was that it’s the first day in the last four weeks where we actually had negative correlation again. We saw bonds rally a little bit while stocks continued to sell off. Bonds may have reflected the fact that there was a bit of an overshoot, from pricing in rate cuts to pricing in hikes. Now bonds are starting to look interesting and all of a sudden the 60/40 starts to look a little bit better.”

The initial sell off in bonds was obvious, Stonehouse explains, because of the war’s impact on headline inflation, which saw rate hikes being priced in. The fall in stocks may seem less obvious, but Stonehouse attributes the pullback to a mixture of elevated sentiment, high valuations, and the view of rising interest rates and input costs as a headwind to margins. Now, however, those growth headwinds are causing bond investors to revise their hiking forecasts and reset the negative correlation.

Stonehouse sees the 60/40 as more attractive now because a prolonged deceleration in economic and earnings growth should be positive for bonds. Should the conflict resolve within the next quarter he believes that growth should resume and stocks will work well through the balance of the year.

While Stonehouse accepts that some investors may see this moment rhyming with 2022’s shocks of high inflation and another conflict involving major energy producers, he believes that this period of similarity is already short-lived. The economic reset and inflation story that emerged from the end of the COVID-19 pandemic was orders of magnitude more significant, economically, than the events in the Gulf. The global economic picture is different, too, with central banks now having room to cut if economies slow further. In watching to see if his thesis, that this is not a true repeat of 2022, holds true, Stonehouse says he will be watching to see if energy-related inflation expectations start to impact pricing on other goods and services. Higher core inflation may keep central banks from cutting, despite slowing growth, which would cause a more prolonged period of positive correlation in the 60/40.

While Stonehouse believes balanced allocations should hold in over the long-term, he notes that we’ve just come off a very prolonged period of inverse correlation, from the late 1990s through the COVID-19 pandemic. He notes, too, that in high inflation periods we can see sustained positive correlations. That’s why he’s been advocating for some adjustments to the traditional 60/40, adding an allocation to commodities.

While the exact per centage of commodities, equities, and fixed income allocation should be determined by the individual investor and their advisor, Stonehouse explains that commodities have recently begun to demonstrate uncorrelated behaviour relative to both stocks and bonds. Energy has been a recent positive story and while gold has pulled back somewhat it has seen a long historic run over the past few years. Global macro trends, from deglobalization, to supply chain reinvestment, to defense spending all support the case for commodities.

Stonehouse’s view is not an exact prescription for when to reallocate and by how much. He instead believes that advisors should start looking to make incremental marginal adjustments, taking advantages of dips and peaks to slowly move towards a new kind of balanced approach that serves their clients well.

“At some point here, this market is starting to feel oversold. People are getting worried. At some point you're going to get a catalyst for a rebound and stocks will rally and bonds probably won't do great for those couple of days… The key thing is going to be how quickly the world returns to normal,” Stonehouse says. “It could be that after that rebound that we're bound to get at some point, you're still stuck in a range. And it feels to me that that's a reasonable prospect here while the markets try and figure out if earnings estimates are too optimistic, if economic growth is still not going to end up being as resilient as people are still pricing it in to be. And that will give you more opportunities, I think, in the coming months to continue to make adjustments towards what you might view to be a prudent target mix.”